Why Power Producers are Headed for Unprofitable Growth

Despite the rise of renewables, declining power prices and decreasing PPA rates are leading to unprofitable growth.

The energy industry today is on the verge of a major tipping point, where for the first time, renewables are reaching significant capacity additions and setting record-low electricity costs that are rivalling those of fossil fuels. This is largely credited towards the continual decrease in the hard and soft costs associated with developing, building and maintaining renewable power plants. However, these changing market forces are creating unprecedented challenges for power producers,as their purchasers are becoming less willing to enter into long-term power purchasing agreements, known as PPAs.

The Trend Towards Unprofitable Growth

The power producer’s business model, which traditionally relies on securing these agreements, is becoming outdated as they are unequipped to keep up with the steady rate of decline in power prices. The consequences of the power purchaser’s unwillingness to sign long-term contracts at a fixed price, paired with the existing inefficiencies of the power producer’s business model have dire consequences – mainly, unprofitable growth.

Every power producer – from the independent provider up to the utility – is focused on growth and generating profits. This is planned for in a number of ways:

Augmenting their project portfolios with diverse technologies in multiple regions

And finally, acquiring or merging with other companies with renewable strong portfolios

In the minds of today’s power producer, growth equates to profitability. While these three methods are certainly aimed at doing just that, external market forces such as low power prices and declining PPA rates are leading to unprofitable growth.

Power Pricing is in Continual Decline

The cost of building solar and wind projects are declining rapidly. Declines in technology, installation, and EPC costs, paired with abundant supply have brought power prices to unprecedented lows; as low as $0.049/KWh in some regions. Solar PV module prices have come down from $82/W in 1976 (current dollar value) to $0.41/W at the end of 2016; representing a learning rate of 28%. This translates to how the cost of new build wind and solar is becoming cheaper than the cost of new build coal or natural gas; a true tipping point in the history of power generation.

U.S. Unsubsidized Levelized Cost of Energy (LCOE)

The levelized cost of wind and utility-scale solar power have undercut that of coal and natural gas, even at their highest estimate. The average price for wind hits under $30/MWh, while solar PV averages just over $40/MWh.

While consumers are benefitting from low electricity costs, power producers, on the other hand, are staring at the prospects of unprofitable growth. In such a competitive market, where the lowest project bidder wins, their profit margins are squeezing tighter. Developers today are trying to produce power at the lowest cost, but their pricing ability continues to decline.

As Off-take Rates Decline, Power Producer’s Business Model is at Risk

Sensing the continued trend of decreasing prices, many power purchasers are feeling less urgency to lock in their rates with long-term contracts, known as power purchase agreements (PPAs). As a result, off-take, or PPA rates have declined rapidly. In just the past couple years, wind and solar PPA rates have dropped across all major regions, with the exception of relatively flat-lined growth in North America (source, Mercatus Energy Insights Report Vol. V). At their lowest, solar and wind PPA rates are averaging below $25/MWh (PV Magazine). As this trend continues without any foreseeable stop in sight, this poses significant challenges to the power producer, whose pricing ability is dwindling down to zero.

Average Off-take Rates by Region (2015-2016)

Over the last year, European off-take rates saw a 44% decrease year-over-year in 2016. Off-take rates also declined 34% in Africa, 38% in Asia, and 37% in South America. In North America, they increased by just one percent.

Wind and Solar Levelized PPA Prices by Contract Year

This graph shows how the levelized PPA prices for both wind and solar have fluctuated over the past decade. While the learning factor for solar power is steeper, wind PPA rates have reached the lowest at just under $25/MWh.

The power producer’s business model is fundamentally driven by historical assumptions rather than forward-looking ones. With power prices continuing to decline, the current model, which is dependent on locking in long-term PPA rates, is becoming less viable. But as the demand for clean, cheap power continues to fuel new development, the power producer’s reaction has been to grow with more projects, in more regions and with more employees. This presents problems since the way businesses structured their overhead costs was originally based on the former high costs of renewable power production. Consequentially, while technology costs have declined overhead costs have remained the same. The consequences of power purchaser’s unwillingness to sign long-term contracts at a fixed price, paired with the existing inefficiencies of the power producer’s business model have dire consequences – unprofitable growth.

Overhead in Distributed Generation

Growth in the distributed generation market has put power producers under a strain like never before. To achieve the same MW output distributed generation requires around 7x the project development overhead compared to centralized generation. However, adding more employees contributes to an increase in operational expenditure and leads to unprofitable growth.

Employees per Megawatt by Generation Type

Over the last 5 years, offtake rates have decreased dramatically whereas FTE costs have remained almost the same. This trend reaffirms that as power pricing margins decrease, and employee costs, businesses are increasingly at risk for profit loss.

Source: Mercatus analysis based on customer data

This is leading to unprofitable growth, so much so that some are deeming the independent power producer’s business model to be “obsolete” and “unable to generate value over the long term.” Findings from a recent study by Ernst and Young affirm this, as EBITDA of independent power producers has gradually decreased over time, both in North America and Europe.

Average EV/EBITDA trading multiples for select North American Utilities, IPPs included (2013–Q1 2017)

In order to avoid unprofitable growth in today’s hyper-competitive energy market, power producers need to take a fresh look at their current operating model for their capacity growth. While low power prices and shorter PPAs are external factors outside of your control, it’s time to focus on what you can control – optimizing your operational efficiency. This means doing more with the same or fewer resources, which includes placing more bids, building more projects, and optimizing plant performance; all without adding overhead costs. For businesses that want to remain competitive and take advantage of the ever-growing opportunities that distributed generation presents, a renewed focus on operational efficiency is key.